Life insurance is one of the most widely used financial products in Canada. However, you probably still have lots of questions around it—especially as it relates to taxes. The complexity of taxes and the long list of terms and conditions on the average insurance policy can leave anyone scratching their head.
Is life insurance tax deductible in Canada? Will beneficiaries pay tax on the payout? Are monthly life insurance premiums deductible? In this blog post, our team at Alliance Income covers many key facts you need to know.
In this article
What Does “Tax Deductible” Mean?
A tax-deductible expense is one you can subtract from your gross income at income tax time. The deduction will lower your taxable income and, by extension, your tax liability.
Life Insurance Premiums Are Not Deductible
Life insurance premiums are not deductible since the law classifies them as personal expenses. Personal expenses can’t be deducted from your gross income when filing taxes.
Life Insurance Payouts Are Tax-Free
It’s important to know that insurance payouts are not taxable. Therefore, you won’t have to worry about your beneficiaries losing a sizable chunk of your life insurance payout to taxes.
Life Insurance Premiums You Pay as an Employer May Be Deductible
If you’re a business owner and you pay insurance premiums for your employees as a benefit, the expenses are tax deductible. However, there are some conditions you must meet to claim a tax deduction:
- You cannot benefit from the insurance policy as the business owner
- You must offer the life insurance policy as a part of the employee benefits package
You can write off all insurance premiums you pay on the policy from your income if the rate remains the same for all your employees, regardless of age or gender. However, if the rate changes based on age or gender, you can’t deduct it as a business expense.
When Do You Need to Pay Taxes on Life Insurance Benefits in Canada?
When people ask, “Is Life Insurance Tax-Deductible?”, they always want to know what happens to the death benefits when they die or to the rest of the policy when they withdraw cash from it.
Generally, neither you nor your named beneficiaries have to pay taxes on life insurance in Canada. However, there are some exceptions to this rule.
You will have to pay taxes on life insurance if you:
Surrender Your Insurance Policy for the Cash Value
Whole life insurance policies with a cash value component will grow on a tax-deferred basis over time. You can use the cash value while you’re still alive. The cash value component is a mixture of the premiums you’ve paid over the policy’s life (cost basis) and the investment gains.
You can access the value by taking a loan against the policy, withdrawing cash from the value, and surrendering the policy completely.
Surrendering the policy is equivalent to cancelling it. The insurance company will deduct the surrender charge upon cancellation before paying you the cash value. If the surrender value exceeds the cost basis, you will pay taxes on the difference.
So, if you have paid $40,000 in premiums over the policy’s life and the surrender value amounts to $50,000, you have to pay taxes on the taxable benefits of $10,000.
Withdraw Money from a Cash Value Policy
You’ll have to pay taxes if you withdraw from your policy’s cash value. However, you won’t need to pay taxes on the total amount withdrawn if it doesn’t exceed the amount you’ve paid into the policy over time.
If the amount exceeds the total premium payments, you’ll pay taxes on the investment gains part of the withdrawal.
Hold a Policy Loan Beyond the Coverage Term
If you took a loan against your insurance policy’s cash component, you must pay off the loan before the insurance term elapses. If your coverage ends before you repay the loan, you’ll have to pay taxes.
However, you will only have to pay taxes on the difference between the loan and the policy basis.
Sell Your Life Insurance Policy
You can sell your life insurance policy if your situation changes and you no longer need it. Some policyholders sell to raise money to manage a terminal illness. Others sell because they can’t afford premiums anymore.
Selling your policy for cash is known as a life settlement. The buyer will take over the payment of monthly premiums, and they will get the death benefits tied to the policy when you pass on.
However, you should keep in mind that life settlements are only legal in Saskatchewan and Quebec. You can’t sell your life insurance policy if you live anywhere else. Even in places where life settlement is legal, insurance providers reserve the right not to allow policy sales.
There are tax implications to selling a life insurance policy, especially if you have a whole-life policy. You will pay tax on any gains from selling the policy beyond the accumulated premiums.
Name Your Estate as the Policy Beneficiary
Ideally, you should name a loved one as the beneficiary on your insurance policy. If you name your estate the policy beneficiary, the death benefit will go to your estate when you pass. Thus, the benefit will be liable to all taxes and fees associated with the distribution of an estate.
After the taxes and fees, the next deductions will be to settle any outstanding debt. The remaining amount will go to any living heirs in your will. If you want your death benefit to go to your heirs as inheritance, you should avoid naming your estate as beneficiary.
Keep in mind that your death benefit can still go to your estate if you don’t name a beneficiary and if both your named beneficiary and contingent beneficiary pass on before you. You can avoid these scenarios by keeping the beneficiary designations up to date and choosing people still far off from the average life expectancy in Canada.
One more scenario in which your death benefit is subject to tax is one beyond your control. Your beneficiaries can receive their payout in full or in installments. If they choose installments, they will pay income tax on any interest earned on the death benefit.
How to Avoid Paying Taxes on Life Insurance
Generally, you don’t have to worry about paying taxes on life insurance. However, to assuage any worries you may have, you can take steps to avoid any of the scenarios we have discussed above.
If you have reasons to sell your policy or access the cash value, talk to your financial advisor first to ensure that you have no other options. If you have group insurance for your employees, talk to an accountant to make sure you fully understand the tax implications (if any).
Get Answers to Your Life Insurance Questions from Professionals
Life insurance is an important but complicated financial product with so much riding on it. You can’t afford to make any mistakes with yours. Are you in need of guidance on any aspect of life insurance? Are you looking for answers to important questions regarding your policy? The team at AIS is ready to assist you. Prefer an exclusively phygital experience? We can do that too. Simply fill out a quote form, and allow our team to begin the process for you online. We look forward to working with you.